Market-based support schemes for renewable energy sources

Abstract

Introduction In the last two decades renewable energy has received increased support from national governments. Directive 2009/28/EC of the European Commission indicates that renewable energy has to provide at least 20% of the European Union gross final energy consumption by 2020. The EU motivated this decision announcing that an increased use of renewable energy is necessary to reduce greenhouse gas emissions complying with the Kyoto protocol while improving security of supply. When designing renewable energy policy for liberalized electricity markets, regulators have a fundamental choice between a price-based and a quantity-based approach. In a theoretical situation of perfect information, both mechanisms obtain the same results, but in practice they experience complementary merits and shortcomings. Key issues are the difficulty of setting the right price in case of price-based instruments and the price risk that is introduced by volume-based instruments. Price-based mechanisms have proven to be effective in attracting investments due to the fixed price that is guaranteed to investors which causes the risk profile of new projects to be low. However, although fixed prices reduce the financing cost of renewable energy projects, the regulator needs to set their levels by estimating the generation cost of each technology. The performance of this mechanism depends to a large part on these estimations and the fact that they have been very effective may indicate that the tariffs where set too high. The fact that many European governments retroactively cut price-based incentives granted to renewable energy sources supports this hypothesis. Quantity-based instruments are also referred to as market-based mechanisms due to the role of the market in defining the price paid to generators. This type of instruments is more effective in controlling subsidy cost and incentivizing producers to reduce costs through market competition. However, its main drawback is the significant price risk faced by generators due to future price uncertainty. This leads investors to require high risk premiums for renewable energy projects at the expense of economic efficiency. The significant price risk may result in market-based policies attracting insufficient investments. In fact, generating companies may be reluctant to build renewable energy generators out of fear of a collapse of the market price. National governments should prefer quantity-based mechanisms due to their ability to control effectively the subsidy cost by limiting the amount of projects being subsidized. In many circumstances the more conservative quantity mode is better for avoiding very bad planning mistakes. The European experience with FiTs clearly indicates that a limit on quantity is necessary to avoid unsustainable subsidy costs from harming the political acceptance of renewable energy and creating a boom and bust cycle in this sector. Retroactively changing the tariffs or introducing taxes on renewable energy generators damages the trust of banks and investors in one country’s renewable energy policy, and may restrain future investments. In conclusion, there is a dilemma between market mechanisms providing an incentive to make an efficient use of resources, thus limiting the cost for society, and market risk deterring investors, resulting in higher financing cost for renewable energy projects and reduced effectiveness. An optimal policy should combine the benefits of a market mechanism with price stability and reduced investment risk. This thesis specifically addresses this issue, answering to the following research question: How may a market-based policy mechanism promote renewable energy development in liberalized electricity markets in the most effective and efficient way for society? This thesis is composed of three studies modeling the impact of renewable energy policy on investments in the electricity sector and two econometric analyses of TGC markets using as a case studies the UK and the Swedish/Norwegian markets. An innovative policy proposal which aims at combining market efficiency with long-term investment stability is presented as a final contribution of this dissertation.

Research method, results and insights The dynamic interactions between renewable and carbon reduction policies The European Union set an ambitious target to lower greenhouse gases emissions and established challenging goals for renewable energy generation. An ETS was established at the European level while support policies for renewable energy are implemented at a national level. Chapter 3 investigates the dynamic interactions between carbon reduction and renewable energy policies. Both policies affect investment decisions concerning conventional and renewable generators in the electricity market, affecting their revenues and the merit order in the market. For the scope of this analysis, a bottom-up investment model is used to simulate the evolution of a hypothetical electricity sector under different policy scenarios. The purpose of this model is to analyze how energy policy instruments affect the investment decisions of generating companies by changing the profit and risk profiles of investment projects. The model applies the notion of bounded rationality, recognizing that investors are not fully rational when making decisions and do not necessarily optimize but rather satisfice. Investors have informational, intellectual and computational limitations. Hence, in the model the agents (generating companies) base their investment decisions on available information and expectations. Investors’ decisions are also affected by past investment choices, which affect their current portfolio, balance sheet and cash position, reflecting path dependency. This study demonstrates that renewable energy policy is necessary because a single carbon reduction policy is not an efficient way of achieving both CO 2 emissions reduction and increasing renewable electricity generation. A combination of both carbon reduction and renewable support policies leads to lower and more stable cost for both policies. However, a high volume of renewable electricity generation could lead to low prices in carbon markets as it has been the practical experience with the EU ETS. This analysis evidences an adverse long-term dynamic effect, namely that low carbon prices may attract investments in coal-fired generators, which could lock the electricity sector into a pathway of higher future emissions. To avoid periods of low carbon prices, regulators may introduce a carbon price floor or adjust the emission cap regularly in an attempt to keep the price within a certain accepted range. Risk-based assessment of renewable energy policy Chapter 4 moves its focuses on renewable energy policy, analyzing the impact of investors’ risk aversion on its performance and comparing TGC markets with FiTs. The analysis is based on the same model used for Chapter 3. The model takes into account investors’ risk aversion and how support policies affect project risk. Two opposite policy options are compared: a FiT system in which investors receive a fixed price for each MWh of electricity produced and a TGC mechanism where the regulator sets the market penetration level of renewable energy and leaves the price setting for every MWh of electricity produced to a market mechanism. Simulations are run changing the risk aversion attitude of investors, comparing its impact on their investment decisions under the two policy scenarios. This study indicates that a TGC market obtains a good performance in terms of cost effectiveness when investors’ risk aversion is moderate; however, its efficiency is negatively affected by risk aversion. On the other hand, FiTs could obtain high economic efficiency if the tariffs are well calculated. Their performance, however, is strictly dependent on tariff levels and could result in either low effectiveness or high inefficiency. In case of flat marginal cost curves, a price mechanism would cause high uncertainty in quantities and a quantity-base instrument would be preferable. This seems to be the case for many European countries which are characterized by a high potential of wind and PV power. Market-based instruments and learning trading agents Chapter 5 takes the analysis a step further and focuses on market-based policies, modeling the impact of adaptive learning strategies on the performance of TGC markets and tendering mechanisms for granting FiPs. For the scope of this analysis an agent-based model is developed in which producers are modeled as adaptive learning agents making decisions about investments and the operation of electricity generators. This study investigates the gaming opportunities arising for producers when confronted with market-based policies and the impact of market power on the performance of these policies. This study evidences a trade-off in the way the two mechanisms allocate risk between consumers and producers. A tendering mechanism involves almost no risk for producers, assuming they perfectly know their generation costs. On the other side, a renewable quota obligation is risky for investors, mainly because demand fluctuations and erroneous forecasts may lead to an over-supplied market and depressed TGC price. Under both mechanisms, the behavior of market participants affects the performance of these policies, causing it to depart from its desired outcome. Producers can easily manipulate both mechanisms for their own profits when supply is concentrated. The results of this analysis clearly indicate that higher competition and lower price risk improve the performance of a TGC mechanism. Hence, regulators may introduce a floor price to reduce project risk. This measure works well if the floor price is correctly calculated. However, this is a rather complicated task for the regulator and an excessively high floor may turn the system into a FiP mechanism. On the other hand, allocating FiP through a tender mechanism can be very cost-effective. These mechanisms, however, grant producers a favorable bargaining position that may lead to above-normal profit margins, reducing policy efficiency. Instead, the bargaining power retained by consumers in TGC markets reduces the profit margin of producers when more competition is introduced. The role of regulatory uncertainty in green certificate markets The first part of this dissertation presents some simulation analyses aiming to predict the performance of renewable energy policy ex-ante. Chapter 6 and 7 take a different approach, instead, developing two ex-post econometric analyses of European TGC markets. Chapter 6 introduces the first analysis which takes the Swedish/Norwegian market as a case study. Price volatility in TGC markets reflects uncertainty over future prices, representing a major source of risk for renewable energy generators. Price risk is considered the principal deficiency of renewable quota obligations since it causes investors to require higher returns. Moreover, investors are exposed to regulatory risk; namely, the risk that a change in the regulation will materially impact the TGC price. Regulatory uncertainty is reflected in market volatility exacerbating TGC price risk. Using an econometric approach, this study investigates the role of regulatory changes on price volatility. As a case study it focuses on the Swedish TGC market which was introduced in 2003 and has become the first multi-national market of this kind in January 2012, when Norway joined the mechanism. A bigger market is expected to guarantee a diversification of natural resources, reducing fluctuations in TGC supply and thus the volatility of market price. An endogenous structural break test is applied to the residuals of a GARCH model to detect changes in the unconditional variance of the TGC price. The test finds two breaks corresponding to regulatory changes occurred in the Swedish TGC market, indicating that the market entered a regime of higher volatility between 2010 and 2011. Volatility was caused by the ambiguity surrounding an increased quota regulation and the creation of a multi-national market. Interestingly, the joint market has not led to a significant decline in volatility compared to past levels, yet. Overall, this study provides evidence for the negative impact of regulatory changes in TGC markets, indicating that regulatory uncertainty leads to increased volatility, exacerbating price risk and restraining investors. For this reason, policy makers should be very careful in changing the regulatory framework of TGC markets. The price drivers of green certificate markets Chapter 7 presents the second econometric analysis which studies the pricing behavior of market participants in the Swedish/Norwegian and the UK certificate markets. This study analyzes the link between TGC prices and the macroeconomic environment, comparing the two countries in the light of their regulatory frameworks. Results indicate that the TGC price in the UK is positively affected by the level of industrial production but unaffected by energy prices which influence the electricity price. On the other hand, the Swedish/Norwegian market follows a long-run equilibrium with energy prices such that rising fuel prices, which lead to higher electricity prices, are accompanied by lower TGC prices. The differences found in the pricing behavior of the two markets are related to the characteristics of the two systems. TGC supply is less flexible in the UK market where wind contributes to more than half of the supply and strict limits are imposed on certificate banking. This leads to a market in which the TGC price is affected by the fluctuations of TGC demand caused by variations in economic activity. In this case, price volatility can be reduced by increasing certificate validity to more than one year. In the Swedish market instead, an important part of TGC supply is obtained from biofuel-fired generators. This, together with no limitation on certificate banking, has led to a more flexible supply of TGCs. The TGC price so reflects the increased cost of producing electricity from biomass as an alternative to conventional fossil fuels, being less dependent on economic activity. Policy makers could create more favourable conditions for investing in low marginal-cost technologies, such as wind generators, by introducing a floor price which reduces project risk. Green certificate options After investigating the impact of renewable energy policy on investments and studying the drivers of TGC market prices, it is clear that the main drawback of a TGC market derives from the uncertainty faced by investors about future project revenues. The European Commission has recently proposed to auction FiPs to provide predictable revenues for investors while preventing an over-compensation for producers, thus limiting the cost to the public. An auction for FiPs combines the best of both price-based and quantity-based instruments and corresponds to a TGC market in which TGCs are traded through long-term contracts. Nonetheless, while this mechanism combines investor certainty with the economic efficiency of a competitive market, it effectively eliminates the short-term market for TGCs. This would reduce allocative efficiency and cost-reduction incentives for generators. Chapter 8 presents a novel approach which allows the regulator to reduce investors’ exposure to price risk, although without completely removing it, maintaining the central role of the TGC market. The proposed mechanism consists in the regulator auctioning call option contracts instead of FiPs. Generators receive a fixed premium in exchange for giving the regulator the right to buy TGCs at a determined price. This premium partially covers the cost of renewable energy producers, reducing revenue volatility and thus lowering project risk. At the same time, option contracts do not affect market liquidity since the regulator maintains the obligation for obliged entities to buy TGCs. In the proposed mechanism, market participants optimize their operational planning according to the electricity and the TGC prices. The TGC market thus maintains a central role, stimulating participants to make efficient use of resources and incentivizing producers to reduce generation costs. The option premium paid to generators also functions as a long-term price indicator to the market, facilitating the strategic planning of investors. This combines short-term operational efficiency with long-term market stability, dampening investment cycles and minimizing the cost of renewable energy subsidies. Conclusions This dissertation focuses on market-based mechanisms and how they can promote renewable energy development in the most effective and efficient way for society. Together with the EU ETS, supporting renewable energy is necessary to achieve a sustainable electricity sector efficiently. Open-ended feed-in mechanisms led to boom and bust investment cycles in many European countries, where national governments were forced to retroactively reduce the subsidy levels and in some cases to suspend the support program in order to limit unsustainable subsidy costs after years of boom in the renewable energy sector. Chapters 3 and 4 indicate that an annual quantity target is necessary to obtain a stable development of the renewable sector and that quantity-based mechanisms should be preferred. Due to the flat marginal cost curve of many RES, price-based mechanisms cause high uncertainty in quantities. Unexpected high volumes of renewable electricity generation may also alter the well-functioning of the EU ETS, causing low carbon prices to attract investments in coal-fired generators which could lock the power sector into a pathway of higher future emissions. Two alternative quantity-based mechanisms have been implemented by policy makers in Europe so far: TGC markets and tendering mechanisms. Chapters 4 and 5 indicates that a renewable quota obligation based on a system of TGCs is risky for investors and its performance strongly depends on investors’ risk aversion. Regulators may introduce a floor price to reduce project risk in a TGC system. The result of this hybrid policy, however, strongly depends on the regulator setting the right price level, similarly to a feed-in mechanism. On the other hand, a tender mechanism is very cost-effective. This mechanism, however, eliminates the short-term market for TGCs, reducing allocative efficiency and cost-reduction incentives for generators. Efficiency is also slightly reduced by the bargaining power retained by investors in the auction that may cause above-normal profit margins for generators. This dissertation proposes an innovative market-based policy, instead. The proposed approach consists in combining a traditional TGC market with a system of certificate call options auctioned by the regulator on behalf of obliged entities. This mechanism represents a hybrid between a TGC market and a tendering system, combining the best characteristics of the two. This system is fair to both consumers and producers, allowing consumers to bargain for a reasonable price in the market while protecting investors with reduced revenue uncertainty. Nonetheless, the European experience indicates that the performance of a TGC market depends on its regulatory framework and policy stability. Flexible TGC supply is necessary for the market to function efficiently, since demand is administratively set and price-inelastic. The green certificate option mechanism is easily combined with technology banding, allowing policy makers to allocate a certain percentage of options to flexible biomass-fired generators. In addition, regulators should permit certificate banking and intertemporal trading. In conclusion, an efficient policy for supporting renewable energy should let the interplay between demand and supply establish a fair subsidy level for renewables. Policy makers should limit their role to defining an annual RES target and the contribution of each technology to it. A third design variable consists of deciding the proportion of fixed and volatile subsidy. The cost structure of some renewable energy technologies, in fact, requires a certain degree of revenue predictability to make these projects easier to finance. So far, policy makers have always opted for either fixed or volatile subsidies. This thesis demonstrates that it is possible to allocate the subsidy level of each technology between a fixed and a variable part, providing regulators with a wide range of options. By tuning the three design variables correctly, policy makers can achieve renewable energy targets efficiently and effectively.